by Wayne Ferbert on January 23rd, 2014

Because 2013 was not! Going in to 2013, we thought that it would be a stock pickers market – meaning you would want to consider picking some individual stocks to out-perform the broader market. We expected to start to see some outlier performance.
 
We were wrong that there would be significant out-performers. Luckily, had you been invested in equities in 2013, you would have done just fine. The amount of outliers on performance was near all-time lows throughout the whole year! It was truly one of those “all boats rise in the tides” sort of a year.
 
You definitely would have been better off just picking indexes and saving all of that time on researching individual stocks. You could have put that time to better use on hobbies or your family time. Most stocks just tended to perform in line with the market – which was up +29% in the S&P500.
 
This chart shows the level of dispersion in the marketplace. Standard and Poor’s Index department produces this report monthly. It basically shows the level of outlier performers to both extremes – down and up. This index is fairly bound by the 4% low level and the 15% upper level. We are just hovering over 4% right now and spent all of 2013 between 4% and 6%. These are very low numbers. 
What does this data mean we should expect in 2014? That is difficult to predict and this index tends to be a lagging indicator - but it is certainly difficult to expect these numbers to stay this low infinitum. But what might cause these numbers to change?
 
We would fully expect a market correction to cause a spike in dispersion. Think of a correction as a storm – instead of all boats rising slowly in the tide, some boats get thrown on to the rocks and crash. That is a likely event in any correction. While corrections can certainly cause most stocks to decrease, corrections have a way of picking some stocks and sectors to beat up way worse than others.
 
So, if there is a correction, I fully expect stock pickers to be rewarded with out-performance – even if that performance might be negative. It is always better to lose less money in the market because of quality stocks in your portfolio than to lose a higher amount to the market index.
 
At Buy & Hedge, we are indexers at heart – and that tends to define a good 80%+ of our portfolio. But we like to exercise our ‘Inner Guru’ and make some stock or sector picks now and then. If there is a correction in 2014, it will certainly test the effectiveness of our Inner Guru stock picker.
 
So, here in early 2014, let’s examine our sectors and find the sector concentration we prefer for the year – or whether we are going to stay in the Energy, Financials, & Technology sectors we have been long for more than a year now!
 

by Jay Pestrichelli on January 21st, 2014

2014 is starting out just the way 2013 ended. The cost of hedging is low low low and the market is pressing up against new highs on a regular basis.   As of the Jan 17th the short-term daily cost was 0.67 basis points per day and the mid-term cost out to September 2014 was 0.79 basis points per day.  
See data for the past 29months on our Resources Page
 
It has been a few weeks since we’ve updated you on this topic, mostly because the story has been the same. However there is one notable point to make. Just after Christmas on January 27th, we hit a new 2 1/2 year low in the cost of hedging.
 
The most notable was the mid-term cost that dropped to 0.79 basis points per day with 174 days till expiration. The strikes to calculate this were about 10% below the market and you could have hedged your portfolio through September’s expiration for only 1.37%.
 
So what are we doing with these low rates, you may ask? The answer is taking advantage of it whenever we can. Most of the hedges that expired at the end of the year got a great new low cost of hedging at higher market levels. However the bigger news is that we think there is affordability to tightening up your hedges by using calls spreads in replacement of long stock protected by a put.
 
For example, say you wanted to put $200k to work in the market today. Buying an SPX (S&P 500) Call for the Jan15 expiration at a strike of 1825 will cost about $10,500. This position has a notional value of $184,000 and is has a max loss of what you paid for the call. We consider this position to have a 5.7% cost of hedging and is the break-even of where the market has to rise to offset it.

Now sell a 2000 strike call (about 10% above market) for $3,000 and you’re net out of pocket is reduced to $7,500.  What you’ve created is a synthetic version of being long $184,000 by only spending $7,500. The max loss is $7,500 and the max gain is growth to the 2000 strike call. That works out to be $10,000 (100*(2000-1825)-7,500).  Or said another way, -4% to +5.5% portfolio range for the year. This is probably narrower of a range than most want, but it shows how you can create a downside limit to your risk and still leave plenty of room to grow.  If you are willing to take a larger loss, these numbers become even more advantageous.

by Wayne Ferbert on January 14th, 2014

The New Year is here and we are back to posting again! Sorry for all that time off but we were busy enjoying our families and the holidays.
 
As a Buy & Hedge investor, the new year is here! Time to look at our portfolio and see if we have achieved the right risk/return balance.
 
Check #1: Are you hedged?
 
First thing to check: Are you sufficiently hedged? This is by far the most important check for the Buy & Hedge investor. Make sure you own all of the hedge protection that you intended. Do you have every share hedged? If not, is that intentional?
 
If you have some shares that are un-hedged (intentional or not), this is a great time to add some protection. The cost to hedge for 9 months and 1 year out is very low as volatility is reaching all time lows.

​But this low cost to hedge might not stick around.
 
Monday's market sell-off won’t cause the price to hedge to go up by itself – not unless we have many more days like Monday. And many days like that in a row will make you wish you had hedged yourself sooner.
 
So, if you have some un-hedged positions, think about buying it now and locking it in for a year.
 
Check #2: Is your allocation in line?
 
US Equities just finished an amazing quarter. The S&P 500 was up over 9% for the 4th quarter! None of the other asset classes really kept pace with that kind of performance. So, you might have a material re-balance to execute.
 
Take a look and if any asset class is more than 3% out of whack – then consider selling the winners and rolling in to the losers. International continues to look like an asset class to own given its relative under-performance to US Equity markets.
 
Check #3: Are you using your IRA accounts to their utmost potential?
 
Remember that your tax-advantaged accounts like IRA accounts are excellent accounts for investing in spreads instead of ETF/stock ownership. You can own a ‘synthetic’ like stock position using the spread instead of the ETF itself. And you will free up a lot of capital that you can deploy in a relatively safe fixed income position like an LQD or IGHG.
 
We really like this strategy because the call spreads right now can be had for really low prices at close to ATM protection levels – and the income from the fixed income ETF can help pay for the cost to hedge.
 
It’s a new year – so make sure your portfolio is ready – especially after the roller coaster ride we endured on Monday!
 
Be hedged my friend!
 

by Derek Moore on January 13th, 2014

With Netflix (NFLX) due to report earnings next Wednesday January 22nd after the close, I thought it was a good time to review the long straddle option trade. Quite often I get questions around how to trade options with earnings announcements. On the surface it would seem easy. Everyone knows earnings can be one of the biggest catalysts in large moves in price. Why not simply buy a call and a put on the same stock the day before earnings as the price is sure to move one way or another?
 
Well, everyone does know this. Especially with high beta stocks such as Netflix that as we will examine can move 25% overnight. Options prices bake in things like earnings releases. The more the market expects an underlying to move, the higher an options price. On the surface buying an at the money call and put, known as a long straddle, seems like a simple trade. But don’t mistake the simplicity with entering the order with the very complex makeup of the strategy.
 
Later we will look at two examples of a long straddle with two completely different outcomes. One would have made $14,925, the other lost $10290. Want to know why?
 
Options traders are making a bet each time on the direction and magnitude of a move. If  price moves greater than expected, traders may make money. That expectation is reflected in what is called Implied Volatility or IV. Unlike Historical Volatility which says what has happened, IV is a forward looking estimation of what will happen. Stocks, ETF’s, and Indexes have an implied volatility. Then each series whether they be weeklies or standard monthly options have their own Implied Volatility.
 
For example, as of midday NFLX weekly options expiring Friday Jan 17th have an implied volatility of 37.69%. The weekly options expiring the following friday Jan 24th have more than double that at 84.47%. Well, this weeks options do not include an earnings release. Next weeks do. Whenever you see spikes in IV, usually a good bet that their is an earnings release or some other news event. For comparison, this week’s SPX options only have a 12.90% IV.
 
So what does this mean to traders? This can be a bit technical but you should if nothing else understand that the higher implied volatility is, the more expensive options are because their is an expectation for bigger moves. Plus, you are starting to get the idea that there is much more involved in this trade!
 
 
Now, a bit of math before we examine to great examples of when the long straddle works and doesn’t work right before earnings. Let’s lay out the steps to figure out what the market is telling us. Many of you remember being graded on a bell curve. The idea that most results will fall in 1 standard deviation 68% of the time. Well the options market through prices is telling us what it thinks a move will be +/- of the underlying.
 
Here are the steps:
 
-Figure the square root of 252. The number of trading days in a year. It’s about 15.8745
-Feel free to round to 16 as many traders do to make next steps easier.
-Divide the IV/15.8745 to get the % 1 day move the options market is pricing in.
 
So we said the S&P options had an IV of 12.90.  If you divide 12.90/15.8745 you get in percentage terms .81%. So what that is saying is the options market is pricing premiums on SPX options expecting a 1 standard deviation move to be +/-  .81% over 1 day. Doing the same calculation, Netflix with an IV of 37.69% would imply an expected daily move of almost 2%.
 
Enough math for now! We need to examine the trades!
 
First example we go back to NFLX on 4/22/13. One day before earnings are released.
 
NFLX priced at $174.37
NFLX IV is 167.28% implying a one day move of 10.54%
4 days to the weekly option expiration.
 
Enter a 10 contract long straddle
 
Buy 10 Calls on April Weekly 175 strike
Buy 10 Puts on April Weekly 175 strike    Net debit of $26.875
 
Next day NFLX moves up 24.4% to $216.99 and this straddle made a profit of $14,925! So your thinking this is easy right? Well, more on that in a bit. What you had happen is the market gapped up much more than the options market predicted. Therefore in hindsight you were able to buy options that were undervalued compared to the move. So what could go wrong?
 
Next example 10/21/13
 
NFLX priced at $354.99
NFLX IV is 128.23% implying an 8.7% one day move.
4 days to the weekly option expiration
 
Enter a 10 contract long straddle
 
Buy 10 Calls on October Weekly 355 strike
Buy 10 Puts on October Weekly 355 strike   Net debit of $45.05
 
After earnings NFLX moves lower by 9.1% or 32.46 points. The straddle lost $10,290. What happened? Netflix didn’t move enough to support the prices you paid to get into the straddle. Now you might be saying, wait a minute. It moved more than expected? Yes, but keep in mind, when you purchase a straddle you are paying higher prices on both the calls and the puts. So you actually need more of a move than you would with just once side of the trade. And, typically after a news event where implied volatility was high, it collapses the next day after the cats out of the bag. In our October example, IV dropped from 138.23% down to 77.86% the very next day. What this drop in IV meant is that options prices reflected a reduced opinion about how far NFLX would move on a day to day basis. Lower expectations for the magnitude of moves mean lower premiums.
 
A few final thoughts. We used the weekly options as they provide a more extreme example of what volatility rising or failing can do to trades. There are many reasons why very short term options might not be the best choice as there is little time to adjust the trade if it goes against you. This wasn’t meant as a vote for or against using the strategy. More, I want you to understand what goes into a very complex trade with a lot of moving parts.
 
What topics would you like to see us cover? Use the comments section below to let us know. 

Posted on December 24th, 2013

We wish all our readers a happy holiday season.

See you in 2014.


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